Two Years Later: Form 1042-S Frozen Refunds

We welcome back a former student of Les and mine, Sonya Miller, who is now an Assistant Professor-in-Residence at the William S. Boyd School of Law, University of Nevada, Las Vegas. She also directs the brand new Russell M. Rosenblum Tax Clinic Program serving low income taxpayers in the Las Vegas area. Sonya wrote one of the most popular posts we have had at PT about the IRS program directed at nonresidents and their requests for refunds. In today’s post she updates us on the program. The program seems to be a situation in which someone saw abuse and the IRS chose a blunt an instrument to combat that abuse. In doing so it caught a lot of people in its net that did not belong there, spent more of its own resources than necessary and paid out several million dollars in interest. The program may have had successes that we do not chronicle because we do not know about them. Perhaps we will learn about them in some future TIGTA audit. Keith

Around this time in 2015, while I was directing the Federal Tax Clinic at the University of South Dakota School of Law, it came to the clinic’s attention that the Service was freezing refunds from Form 1042-S withholding for nonresident students at the University. The clinic and I wrote about the issue in Procedurally Taxing here. At that time, dealing with the Service to represent these taxpayers was extremely frustrating; it was like talking to a brick wall. Repeated phone calls to the practitioner priority line yielded virtually no information. We contacted the Taxpayer Advocate Service (TAS) for assistance and still it was slow going. This is likely because, as the National Taxpayer Advocate (NTA) noted in her Fiscal Year 2016 Objectives Report to Congress, the Service directed taxpayers to contact the Taxpayer Advocate Service (TAS) for assistance but had not provided TAS with any specific procedures or protocols that could be followed to assist these taxpayers. Indeed, in her Fiscal Year 2017 Objectives Report to Congress, the NTA notes that the Service was no more forthcoming with TAS than it was with other third parties: “The National Taxpayer Advocate and her staff raised concerns about the matching program and the student Form 1042-S issues. These concerns, however, were repeatedly dismissed by the IRS officials charged with operating the program.” On behalf of affected taxpayers, TAS issued mass Operation Assistance Requests and developed Taxpayer Assistant Orders.

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The NTA further noted in her report the unfair burden the Service placed on compliant nonresident taxpayers in an attempt to catch a few bad actors, while leaving compliant taxpayers with virtually no recourse for proving that they were entitled to the frozen refunds. Indeed, this was our experience at the South Dakota clinic. Early on in representing our student taxpayers, we contacted the University’s comptroller and received proof that the University had in fact withheld taxes from the students and had turned the money over to the Service. Still, the Service refused to release the refunds. It took so long to get the refunds released that I cannot be sure that it was our representation of the students that caused the Service to finally release the refunds. By the time the students contacted us, the refunds from their 2014 Forms 1040NR had been frozen for five months or more. Some of the students waited over a year to receive their refunds.

To be fair to the Service, it was trying to prevent fraud. Even so, no such burden exists for domestic taxpayers whose withholding agents fail to turn over withholdings. When an employer fails to turn over payroll tax to the Service, domestic taxpayers are still entitled to receive a refund from any over withheld taxes. Moreover, the Service’s means (trying to match the information in each and every Form 1042-S reported by withholding agents to each and every Form 1040NR or 1040NR-EZ filed by taxpayers) to reach the end of preventing fraud, was a blunder, which the Service recognizes in hindsight. However, the Service does attempt to place more of the burden on withholding agents by disincentivizing bad behavior. Withholding agents face hefty penalties if they fail to meet the requirement to file Forms 1042-S. They also face penalties for failing to furnish correct Forms 1042-S to recipients. Failing to ensure that Forms 1042-S reported to the Service exactly match the forms provided to the taxpayer is one common mistake that withholding agents make. Treasury Regulation 1.1461-1(h) lists the code sections for all of the penalties to which withholding agents may be subject.

However, notwithstanding its limited resources, as the NTA highlights, the Service could always do more to use its resources effectively. In her Fiscal Year 2017 Report to Congress, the NTA states that the Service’s verification process for refunds based on Forms 1042-S “has not only been costly for taxpayers, but for the IRS, which has estimated that an extension of the freezes through early 2016 would generate an interest expense of over $4 million.” She further states that the Service could have maximized its resources had it “simply used technology already developed and pre-tested in the domestic withholding context” rather than using a separate, systemic matching program.

In an effort to “try harder and do better,” it has been reported (full text on file with the author) that the Service will no longer systemically freeze all refunds based on Forms 1042-S and will manually review all frozen refunds. The service describes its matching program in IRM 21.8.1.11.14.2. Unfortunately, we the people are not privy to most of the information in this IRM—the Service has heavily redacted it. It seems that the Service redacts information for fear that people will use the information to game the system. So, if I had to hazard a guess, in line with the de minimis exception in IRS Notice 2015-10, the redacted information probably says something about which refunds will be systemically frozen and which will not and that there’s a threshold amount to make this decision. Nevertheless, in IRM 21.8.1.11.14.3, the Service does set out what the matching program looks for in determining a good match. Where refunds are frozen, the freeze will systemically release after a little over five months. Also, IRM 21.8.1.1.13, informs IRS employees that nonresident taxpayers have rights under the Taxpayer Bill of Rights, which means that the Service cannot just keep nonresident taxpayers in the dark regarding the status of their refund claims. Change has been somewhat slow but the Service has taken responsibility for its transgressions and appears to be moving in the right direction.

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Comments

1. Had the same issue with one NR that claimed a 2014 refund of $386,000 and a 2015 refund for $385,000. I knew about the 6 months freeze of 2014 and called the Practitioner Hot Line in May 2016 (the return was filed on 9/10/15). A nice assistor looked at it said he saw no reason to hold it and a check came in about 3 weeks. For 2016 I had to call twice. The first call was a waste of time. The second call produced a strange observation from the assistor: Could your client be a victim of identity fraud? I assured her that he was not. (Maybe there was a code to that effect). She asked me to check in 2 weeks but when I checked the client’s account on the IRS computer a week later I saw that a check was sent. The client received over $400,000 (interest, interest). It may be that Parkinson’s law is in effect. For those not familiar with Professor Parkinson books (written mostly in the 1950s)- a civil service employee can relate to a small amount within his comprehension and then delay refunds or release the refunds. When it comes to large amount, which he has never seen, it is beyond his comprehension and he figures that the caller is correct.

2. Relating to this issue- AT least 2 2015 NR resident returns (1040NR), claiming refunds (one is 50K the other is rather small )that were sent to Austin but certified mail for which I have proof of delivery seem to have evaporated into the ether. I wonder if other had the same problem and if Austin is copying the Philadelphia service center of the 1980s with the famous ceiling that collapsed.

I too lived through this as well with a handful of clients, Sonya Miller is a hero. Abe regarding point 2 in your comment I too experienced several incidents of certified return receipt mail disappearing out of the Austin Service Center, alarming and annoying.

Thanks Sonya for your exceptional work and advocacy on behalf of our clients and the large number of people that were and have been affected by the automatic freezes. Also, congratulations on the establishment of the new clinic! Your perseverance in the face of these immense challenges is a tribute to your devotion to our low income taxpayers and their families! Thanks!

“At that time, dealing with the Service to represent these taxpayers was extremely frustrating; it was like talking to a brick wall. […] We contacted the Taxpayer Advocate Service (TAS) for assistance and still it was slow going.”

It’s the same for US citizens who live outside the US. The IRS sends us letters telling us to call US phone numbers toll free, but ATT blocks our attempts to call toll free. The IRS tells us to write to IRS addresses shown at the tops of letters, but the IRS ignores our letters. TAS acknowledges our letters but never does anything.

Meanwhile, there are big problems with Forms 1042-S, maybe bigger than 1099. One unusual IRS employee made a half-hearted attempt to help one time, teaching me about Form 4056-T. I requested transcripts of withholdings that payers reported on both Forms 1099 and 1042-S. The IRS had no records of any of the withholdings.

TIGTA and DOJ have reported arrests of IRS employees for embezzlement from Forms 1099, but not (as far as I’ve seen) from Forms 1042-S.

Normally US citizens never knew the existence of Form 1042-S. US payers took withholding from interest or dividends that they paid to stockbrokers, and now that I know about Form 1042-S, I guess payers issued those forms to stockbrokers, but stockbrokers weren’t beneficiaries so they didn’t file US tax returns. Payers didn’t know that some beneficiaries were US citizens, and stockbrokers also didn’t know until around 2002, so Forms 1042-S sat unused in brokers and embezzlers could keep the withholdings without getting caught. We started getting Forms 1099 when brokers contracted to be qualified intermediaries, we filed Forms 1099 with US tax returns, the IRS started freezing our refunds, and the IRS had to take further actions to cover up embezzlements.

So now the IRS freezes refunds on Forms 1042-S too. No one conducts audits to follow the money and find where the withholdings went. Why is anyone surprised.

After a few years of studying, as far as I can tell, even when withholding is reported on Form 1042-S instead of 1099, when IRS records don’t show the withholding that a tax return declares, the IRS has to issue Notice CP-2000 to beneficiaries and contact payers to find out if the return’s declaration is correct. I bet the IRS has never done so, and I bet no other victims even figure out this much.

“Where refunds are frozen, the freeze will systemically release after a little over five months.”

Oh lucky them. When refunds from Forms 1099 are frozen, it takes decades, or maybe never.

Another commenter wrote: “The second call produced a strange observation from the assistor: Could your client be a victim of identity fraud? I assured her that he was not.”

Great piece, Sonya. A few years back, my firm represented a Mexican national who had invested in a viatical insurance policy issued by a Florida insurance company and received payment on that policy after the beneficiary’s death. The insurance company withheld 30% of the policy proceeds paid to my client (about $150K) and issued a 1042-S to the IRS. The client had filed a 1040-NR, claiming a refund of most of the amount withheld based on treaty benefits provided by the U.S.-Mexico tax treaty. That claim sat for over 6 months, unacted upon, in IRS International in Philadelphia, which handles 1040-NRs. Although we obtained bank documentation from the Florida insurance company, establishing that it remitted the withheld amount and sent the Form 1042-S to the IRS, we were unable to pry loose the refund. IRS International then issued a notice of disallowance, which a triggered a 2-year period to file suit. We then dealt for more than 1 year with a rotating cast of employees at IRS International, who repeatedly promised to recommend allowance of the refund but never delivered. We had filed a Protest of the disallowance notice with IRS International but it failed to forward the case to Appeals with sufficient time left on the 2 year refund statute to do anything in the case. We then enlisted the assistance of the Taxpayer Advocate Office to pry loose the refund. The TAO almost succeeded in getting the refund issued but the refund statute was getting too close and there was no assurance that the IRS would authorize issuance of the refund in time. We were thus compelled to file a refund suit in the Claims Court, which DOJ conceded soon after filing of the action.

In short, what should have been a slam-dunk contingency fee case to recover a tax refund that was indubitably owed to the taxpayers turned into a prolonged ordeal for both the clients and us. Never before or since have I dealt with so many incompetent bureaucrats as those in IRS International. And that’s saying quite a lot for the IRS. 🙂

Refunds of FIRPTA withholding are slow – can be over a year from time of tax return submission to refund. Probably the refund size holds it up (15% of sales price of Real Property in excess of $300,000).

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Leslie Book

Keith Fogg

T. Keith Fogg is a Clinical Professor of Law at Harvard Law School where he started a tax clinic in 2015. Prior to joining the faculty at Harvard, he began his academic career at Villanova Law School in 2007 after working for over 30 years with the Office of Chief Counsel, IRS. Read More…

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